The Paradox of Innovation

Over the past few weeks I've been researching different start-ups and venture capital firms.  During my adventures around the datasphere, I ran into a few ideas and notions that piqued my interest.  I will highlight two of these in this post.

The first is the basic nature of innovation.  It is both essential to the functioning of capitalism and remarkably unprofitable.  The reason innovation tends to be unprofitable is because it is much more likely for a given innovation or start-up to fail than to succeed.  This led me to consider the futility of the rational, profit-maximizing model in accounting for such a fundamental aspect of capitalism.  What then, leads people to innovate?  Is it a survival instinct?  "Animal spirits"?  Risk preferences?  This is a basic question that appears to still be largely unanswered.

The second was that venture capital is not all it is cracked up to be.  By this I mean, the image of venture capital as a supporter of innovation, start-ups, and the "small guy" does not appear to be all that true.  Maybe this was a mistaken notion I had, but my sense is that this is a broader misconception.  As this blog post indicates, after years of meagre and negative returns, venture capital now tends to avoid true start-ups and bet more on tested business models and experience.  This feels distinctly anti-innovation.  By definition, innovation is something that has not been before.  This means that the next Google or Facebook will seem like a weird/crazy/idiotic idea now; and that's the point.  It's interesting to note that both Google and Facebook were turned down in their attempts to solicit venture capital funding.  I would guess that the conservative approach to innovation in venture capital firms is likely tied to the pressure on people making the investment decisions.  For example, when the 19 year-old working out of a garage on some outlandish idea you invested in fails, that is tough to explain to the investors who trusted you with their money.  With a failed bet on a tried business model run by experienced business men, you can more easily justify your decision.  The inherent unprofitability of innovation has probably forced vc firms farther down the innovation chain, which means other sources of funding will remain important.  

EconTalk Podcast

Here is a link to an EconTalk podcast by Larry White and Russ Roberts in which they discuss business cycles, money, and Hayek. I found two sections of the podcast particularly lucid and perspicacious:

1. The central bank's role in creating bubbles

and

2. The importance of the velocity of money

In the absence of a central bank, the interest rate serves to balance the amount of savings and investment in an economy. During times of innovation, for example, entrepreneurs seeking funds for new investment opportunities will bid up the interest rate, ensuring only those new projects that are forecasted to be the most profitable get undertaken. In addition, the higher interest rate redirects savings from the least profitable, older investment opportunities to the most profitable, new opportunities. The limited nature of real resources and savings renders this reallocation essential.

When a central bank enters the picture, the automatic interest rate rise that occurs when new entrepreneurs start competing for finite savings is impeded. The central bank may be slow to raise interest rates, accommodating both the least profitable, older investment opportunities, and the most profitable, new opportunities. Larry White points out that this creates the illusion that there are more savings than there actually are, leading to overinvestment. Prices begin to rise as more and more firms financed by the cheap credit bid for scarce inputs. Leaving interest rates low accelerates this inflationary process, so the central bank will likely raise interest rates - cutting the supply of cheap funding and spelling doom for many borrowers. This kind of overinvestment bubble exaggerates a genuine innovation boom, and points to the role central banks play in perpetuating this type of bubble.

In another section of the podcast, Larry and Russ discuss the importance of the velocity of money. They begin with the equation of exchange MV=PT, which is essentially an identity between total spending and total income. The "V" in the equation is the velocity of money, or the rate at which money is changing hands. What I found interesting is how Roberts framed "V" as a measure of the general psychology in the economy, and in particular, expectations about the future. When people are unsure about future economic conditions, they tend to hold onto their money and spend less until the future becomes clearer.

We are seeing this in the economy today - there has been an enormous increase in M, but since V is so low, the increase in M has not had the predicted effect. However, the efficacy of increasing M to spark recovery is undermined by the difficulty in measuring V. If we do not have an accurate measure of V, there is no way to know how much M should be increased for the desired effect. Thus, the next best solution is to strive to stabilize V. In other words, stabilize people's expectations about the future. This includes expectations regarding inflation, tax conditions, and the regulatory environment. None of these areas are at all clear in the current climate, leading to the current difficulties jumpstarting the economy with traditional monetary and fiscal policy. For any hope of a recovery, stable policies should be put in place in order to anchor expectations about the future.

Obama's Jobs Proposal

Obama recently proposed a small business jobs and wages tax cut as part of his campaign to increase job creation, and aid the economic recovery. The proposal has three key aspects:

1. Businesses will receive $5,000 for every net employee they hire in 2010. This credit is capped at $500,000 per firm to ensure small businesses receive the majority of the credit.

2. Businesses that increase wages and hours for existing workers will be reimbursed for the Social Security payroll taxes they pay on wage increases above inflation. This credit does not apply to wage increases above $106,800.

3. Companies can claim these credits on a quarterly basis.

This is a purely supply-side stimulus proposal, meaning, these tax credits will have no affect on the underlying demand for the products of these businesses. In other words, while facing the same level of demand, and therefore revenues, firms must increase their costs in order to take advantage of this tax credit. Ergo, the firms best-placed to take advantage of these tax credits are those firms that are already recovering and already thinking about adding new workers or increasing wages. While firms on the margin deciding whether or not to add a worker or increase wages will also be impacted, firms struggling the most will be unaffected by this subsidy as they have no room for any increases in costs.

I believe this proposal is largely a political maneuver, and will prove futile in creating the amount of new jobs alluded to in the administration's rhetoric. By targeting already rebounding businesses, the administration simply piggy-backs their recovery and will probably attribute these business' recovery to this subsidy in the future. Indeed, this subsidy will create some jobs on the margins, but many of the jobs that will be attributed to this subsidy would have been created without this subsidy. In addition, when tampering with the tax code, one must always consider the skewed incentives. This subsidy is no exception. Individuals currently working for a struggling businesses will have an incentive to quit their jobs and move to companies that are positioned to take advantage of the subsidy, and thus receive higher wages. This can hardly be considered job creation. This proposal, while not overly harmful to labor markets, will ultimately prove impotent at its goal of job creation.